Is impact investing a risky business?
As a growing number of asset owners question whether they can manage their assets for more than financial returns, impact investing receives mounting attention. In spite of this, many still believe that impact investments constitute higher risks. We explore how by reframing their relationship to risk, family offices can take bigger bets and win in the long run.

By Francois Botha & Rachel Browning
Published on Simple October 26, 2020

Impact investments are designed to generate a measurable, beneficial social or environmental impact, alongside a financial return. As a growing number of asset owners question whether they manage their assets for more than financial returns, impact investing requires mounting attention. In the latest report by the Global Impact Investing Network (GIIN), the global impact investment market has been estimated to be worth more than half a trillion dollars qualifying it as one of the fastest-growing areas of asset management.

Partially fuelling this impact-zeitgeist, are the next-generation of investors who are looking to leverage their capital to make the world a better place. By paying due attention to this macro-trend, family offices are able to engage with the next generation and co-create a future where investing in impact businesses is the norm.

In spite of this growing accolade, many still believe that impact investments constitute higher risks. How do costs, due diligence, and return timelines play out within impact investing? Does investing with your values mean you have to sacrifice on returns? Answering such questions requires a revision of existing investment logic.

From Black to Green Swans

In New York Times 2007 bestseller, ‘The Black Swan: The Impact of the Highly Improbable’, former risk analyst Nassim Nicholas Taleb argues that what we don’t know is far more relevant than what we do know when calculating risk. The black swan logic argues for the extreme impact of rare and unpredictable outlier events – such as the rise of Google as a global powerhouse and the 9/11 terrorist attacks – and how through reframing our relationship to risk, society can better withstand these difficult-to-predict events.

Rather than understanding probability as a computation of odds, Taleb reframes probability as an acceptance of what we don’t know. The ultimate task for us is to develop methods to deal with this ignorance.

Most recently discussion has moved from black to green. John Elkington, the founder of the triple bottom line (people-planet-profit), has introduced the idea from Green Swans. Though sustainability and CSR have had a long history, the current climate crisis has brought the green transition front and centre of international discussions.

Impact investments are designed to generate a measurable, beneficial social or environmental impact, alongside a financial return. As a growing number of asset owners question whether they manage their assets for more than financial returns, impact investing requires mounting attention. In the latest report by the Global Impact Investing Network (GIIN), the global impact investment market has been estimated to be worth more than half a trillion dollars qualifying it as one of the fastest-growing areas of asset management.

Partially fuelling this impact-zeitgeist, are the next-generation of investors who are looking to leverage their capital to make the world a better place. By paying due attention to this macro-trend, family offices are able to engage with the next generation and co-create a future where investing in impact businesses is the norm.

In spite of this growing accolade, many still believe that impact investments constitute higher risks. How do costs, due diligence, and return timelines play out within impact investing? Does investing with your values mean you have to sacrifice on returns? Answering such questions requires a revision of existing investment logic.

From Black to Green Swans

In New York Times 2007 bestseller, ‘The Black Swan: The Impact of the Highly Improbable’, former risk analyst Nassim Nicholas Taleb argues that what we don’t know is far more relevant than what we do know when calculating risk. The black swan logic argues for the extreme impact of rare and unpredictable outlier events – such as the rise of Google as a global powerhouse and the 9/11 terrorist attacks – and how through reframing our relationship to risk, society can better withstand these difficult-to-predict events.

“People are often ashamed of losses, so they engage in strategies that produce very little volatility. But contained within this is the risk of a large loss. It’s like collecting nickels in front of steamrollers”
Nassim Nicholas Taleb, author of ‘The Black Swan: The Impact of the Highly Improbable’

Rather than understanding probability as a computation of odds, Taleb reframes probability as an acceptance of what we don’t know. The ultimate task for us is to develop methods to deal with this ignorance.

Most recently discussion has moved from black to green. John Elkington, the founder of the triple bottom line (people-planet-profit), has introduced the idea from Green Swans. Though sustainability and CSR have had a long history, the current climate crisis has brought the green transition front and centre of international discussions.

Responsibility has been replaced for resilience. ‘Black Swan’ events are those that happen when we are no longer paying attention. ‘Green Swan’ events, by contrast, will happen when we consciously decide to take responsibility for the future.

“Green Swans are dynamics, trajectories, pathways that take us exponentially towards the things we want to see. There has to be intentionally and political will and investment over fairly protracted timescales”
John Elkington, author of ‘Green Swans: The Coming Boom in Regenerative Capitalism’

Risk, return… impact?

Traditionally, the central premise of investing revolves around the principle of risk and return. The higher the risk, the higher the potential reward. Based on this premise many investors believe there’s a trade-off between impact (social and environmental returns) and risk-adjusted financial returns. In other words, the more significant the impact focus, the lower the return on investment.

Impact investors believe they may also incur additional costs in identifying and evaluating the organizations in which they’re considering investing. Add to this transactional cost, exit, impact, and reputational risk factors as well as the degree of uncertainty in entering new markets and it’s easy to see why impact investments, at least at face value, are often perceived to be riskier propositions than most other forms of investment.

Yet if we use existing investment logic to determine whether impact investments are higher risk or not, we’re missing a trick. New fields require new thinking. When it comes to impact investments, a new investment paradigm is emerging. Risk, return, impact. By broadening this two-dimensional risk and return assessment when considering investments, families are able to insight into their impact objectives and risk appetites.

For family offices considering impact investment, there is a need to define which risk factors are most important to them. By establishing a clear definition of risk and impact objectives, risk appetite, and impact tolerance will become more apparent. From here, it will be easier to identify investments that would be a good fit as well as those that wouldn’t, saving valuable time and resources when choosing between investments.

The due-diligence challenge

Due-diligence is a word that can make even the most experienced investor shudder. Luckily over the past 50 years, software platforms and services have emerged in order to ease this pain. But the idea that impact investing can be associated with more expensive, complicated, time-consuming, or incomplete due diligence may not be an attractive option. How does an investor rise to this challenge?

“Instead of trying to attempt something entirely new, investors can just broaden what they do already. Expand on your existing due diligence by asking some more exploratory questions and this will start your journey.”
Mette Fløe Nielsen, Impact Investor and Board Member

Moreover, the growing consensus within impact measurement is a further sign of things to come on the due-diligence front. The Impact Management Project, a forum for building global consensus on how to measure, manage and report impact, highlights that any type of impact experienced by people and the planet needs to understood across five dimensions of impact. Intended or unintended, positive or negative – impact must be measured and managed. These five impact dimension – What, Who, What, Who, How Much, Contribution, Risk – aims to give a holistic assessment of impact.

By using this framework, investors have a way to consistently classify each investments ‘impact class’ within a multimanager, multi-asset class portfolio. When implemented at the due diligence phase, the framework can help the family office to build a total portfolio view of its impact and set a baseline for managing performance over time.

As with the ESG industry, there is little doubt that impact due-diligence will improve over time. Investments, regardless of their nature, are still investments. When it comes to due diligence, they need to be treated as such. Keeping these facts in mind can help to focus on getting answers to questions in any area of concern.

Setting the right time horizon

Crucial when exploring this new field is looking to the right time horizon. Good impact investments could, in theory, offer investors different levels of return in the short-, medium- and long-term. Time horizons are dependent on the nuances of each investment.

It’s worth remembering, however, that by nature impact investments are more ambitious as they focus on radically changing the status quo. Even if financial returns may only be realized in the longer term, investments could see social returns in the short- and medium-term. For family offices, it is work considering the value of short-term impact versus long-term legacy.

Impact investing presents some genuine challenges in the areas of risk management, due diligence, and return timelines. Do these mean it always has to be a higher risk? No.

Family offices that have defined risk tolerance and who have clearly set out objectives and instruments of measurement are better positioned to match opportunities to their risk appetites. If we are to understand risk as an acceptance of what we don’t know, rather than a computation of odds, impact investments and their forward-looking premise might well be the most secure bet in the long run.

About the Authors

Francois Botha

Simple Founder. Strategy Advisor

Francois believes that the next generation of family leaders need new, simple tools and trusted experts with a fresh outlook.

Connect with Francois Botha View Francois Botha Profile

Rachel Browning

Impact Investment Advisor

Rachel has dedicated her career to looking at how we can make investing more directed and meaningful through ESG and Impact investing.

Connect with Rachel Browning View Rachel Browning Profile

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