Moving Beyond the Trade-Off Debate
All Kinds of Capital for Complex Problems
Impact investing is on the rise. It has grown from a nascent concept into a sizable and sophisticated sector with more than $228 billion invested, representing a fourfold increase since 2014. More generally, the Global Sustainable Investing Alliance reports nearly $23 trillion in assets using socially responsible investment strategies.
The trend is clear: Everyone from high-net-worth families to foundations, pension funds to insurance companies, is seeking to align investments to values.
And this growth has affected the philanthropic sector as well. Foundations are thinking more creatively about how to best use impact investing to advance their missions and looking beyond program-related investments to leverage the other 95 percent of their assets for mission-related investments. High-net-worth individuals are also increasingly setting up philanthropic vehicles that allow them more flexibility in pursuing for-profit investing alongside nonprofit grants.
Omidyar Network is extremely excited about the future of the industry — but this potential is significantly hindered by an increasingly polarized debate about whether impact investing requires a trade-off between financial return and social or environmental impact.
One perspective claims that there is always a trade-off between return and impact and that all true impact investing therefore involves concessionary, or subcommercial, returns. The opposing perspective is that there is never a trade-off, and thus that all smart impact investments should achieve full commercial, market-rate returns. Combined with the rapid growth in size and diversity of impact investments, these competing claims fuel confusion that threatens to leave critical capital on the sidelines. While the first perspective may scare off commercial capital that is essential to scaling promising solutions, the second risks dismissing as “bad deals” rigorous subcommercial investments generating types of impact that are possible only with more flexible capital. The reality is far more nuanced.
With nearly 15 years of experience, we believe the entire continuum of capital has a vital role to play — and we are not alone. In Beyond Trade-Offs, our new series published on The Economist’s digital platform (beyondtradeoffs.economist.com), a chorus of leading impact investors make the case that the full spectrum of impact investing capital is essential to achieve bold and lasting change. As such, we think the series is an important read for any philanthropist aspiring to have a meaningful impact on the issues of our day — from climate change to global poverty.
For the philanthropic world, it has become clear: Now is the time to be creative in leveraging impact investing’s full continuum for maximum impact; to activate untapped assets that can make a meaningful difference even in the pursuit of strong financial returns; and to double down on the all-too-scarce subcommercial capital that foundations and wealthy families are uniquely suited to deploy.
Moving Beyond Trade-offs
Omidyar Network brought out the concept of a spectrum of investment opportunities in our 2017 article “Across the Returns Continuum,” which introduced our framework for evaluating financial returns and social impact.
An investment can have both a direct impact on the customers or beneficiaries of a company, and a market-level impact that often drives sector-level change. Understanding these different types of impact led us to different expectations for financial return and risk. When investing in companies pioneering new models, providing industry infrastructure, or influencing policy discussions, we’ve found that achieving market-level impact often requires flexibility on financial returns or risk – sometimes both. While we seek to drive strong direct impact with every investment along the continuum, market-level impact is at the core of our decision-making in those cases where we decide to accept subcommercial returns or make grants.
Many foundations, philanthropists, and investors have already moved beyond the trade-off debate.
The response to “Across the Returns Continuum” revealed that many leading impact investors — from all corners of the market — are eager to move the field beyond the tired and troubling trade-off debate. Toward that end, we came together in Beyond Trade-Offs to collectively advance a set of shared fundamental beliefs.
Investors contributing to the series target different asset classes, social issues, and geographies, and they do so from starkly distinct mandates — and yet they all agree that there is a broad range of viable impact-investment profiles, some of which involve a choice between impact or financial return, and some of which do not. Beyond Trade-Offs explores how family offices, foundations, and institutional investors match their capital with expectations for risk, return, and impact in specific market segments, as well as the rigor they bring to decisions in which they accept below-market returns.
To be sure, there is no single “right” way to do impact investing, but key themes emerged from this group of leading impact investors.
A Continuum Approach
If we learn one thing from Beyond Trade-offs, it is that many foundations, philanthropists, and investors have already moved beyond the trade-off debate to develop sophisticated approaches that deploy capital at multiple points along the continuum.
One prominent example from the philanthropic world is the Ford Foundation, which — building on the foundation’s long-standing program-related investment strategy — recently committed to allocate up to $1 billion of its endowment to mission-related investments over the next decade.
Less well-known in this context is Prudential Financial, which has invested more than $2.5 billion for impact in three distinct portfolios. All three are managed for impact, but with differing expectations for risk, financial return, and impact. Prudential’s largest portfolio — roughly 80 percent of its impact assets — seeks risk-adjusted, market-rate returns across a range of asset classes. Meanwhile, its “catalytic portfolio” is poised to take on greater risk and consists of smaller, unproven investments where Prudential is frequently the first institutional investor. The outsized risk results in lower average returns on the portfolio, but Prudential has found that individual transactions can perform extremely well — so well, in fact, that they routinely become future sources of financial returns in its main impact portfolio. The final portfolio is managed on behalf of The Prudential Foundation and exclusively provides concessionary capital to nonprofits. Prudential pursues this three-part strategy because its leaders believe it will lead to more impact than any one portfolio could achieve on its own.
This motivation is shared by Liesel Pritzker Simmons, co-founder and principal of Blue Haven Initiative (BHI), an innovative single-family office.
“Complex problems call for all kinds of capital,” Ms. Pritzker Simmons says. “We believe that playing across the returns continuum expands our opportunities to have scalable impact.”
This gets to the heart of the trade-offs debate: Savvy investors can and do achieve impact alongside market-rate returns, but sometimes choose to forgo a full return in pursuit of other types of impact. For Prudential, the below-market capital it provides to nonprofits means lower-interest loans to the vulnerable populations those nonprofits serve. For BHI, it means a chance at a step-change energy solution for underserved rural communities. (See box on Page 41.)
Embracing the full continuum is not only powerful for individual philanthropists, it is also critical for the market to achieve its full potential. As such, there is room for all types of capital — not least the assets that come to impact investing with a narrower mandate. That brings us to the second theme, key for foundations that aspire to leverage their endowments to advance their charitable mission.
Several contributors to the Beyond Trade-Offs series demonstrate that under certain circumstances it is possible to achieve risk-adjusted, market-rate returns with substantial social impact.
Savvy investors can and do achieve impact alongside market-rate returns, but sometimes choose to forgo a full return in pursuit of other types of impact.
For chief investment officers charged with growing endowments to fuel the foundation’s future, Prudential’s experience inspires confidence. “Our experience is proof that it is possible to incorporate impact strategies with the norms and constraints faced by institutional investors,” says Ommeed Sathe, vice president, Impact Investments, Prudential.
Based on its first year of investing its endowment for impact, the Ford Foundation would concur. However, Ford cautions that doing so doesn’t mean single-mindedly pursuing the highest promised financial return. Instead, it requires a clear-eyed analysis of whether an investment provides an appropriate return for the actual risk entailed.
“Those seeking to avoid ‘concessionary’ investments should take care to ensure that they aren’t automatically ruling out opportunities simply because they have lower returns than competing products might advertise,” Ford warns. “Those lower return opportunities may be well-priced for risk taken and help investors achieve their overall portfolio return objectives.”
Such impact investments can deliver not only competitive financial returns, but also meaningful impact. As defined by the Impact Management Project, investors can contribute to the impact of an investment via four strategies: signal that impact matters, engage actively, grow new or undersupplied capital markets, and provide flexible capital. Multiple authors in the series leverage a combination of the first three strategies to enhance the impact of a company without sacrificing financial returns.
For example, Elevar Equity’s commercial success depends on identifying the nuances of self-evident, demonstrated demand and in timing an investment to match customer readiness in undersupplied capital markets. Achieving this aligns impact objectives with financial returns. Similarly, The Rise Fund seeks “co-linear” investments — where the drivers of financial success also contribute to the impact of the investment — and engages actively with portfolio companies to ensure impact scales alongside financial returns.
Meanwhile, Goldman Sachs has helped several clients to identify creative ways to increase the impact that they are able to achieve across a fixed asset allocation, even in public markets. The McKnight Foundation, for example, makes the most not only of its committed endowment capital, but also of “sweat equity” to advance its climate-change goals.
Investors constrained to market-rate investing will inevitably bump up against some limits — whether in geography, sector, or customer demographic. Nevertheless, even within these constraints, investors are proving new methods of contributing real impact from market-rate portfolios. Given the magnitude of the problems we collectively aim to solve, serious philanthropists can’t afford to leave this impact on the table.
Finally, leaders in the field also identify some types of impact that are not conducive to market-rate returns, and their experience underscores the importance of rigor in making decisions about when and how to deploy subcommercial capital.
One vital role for subcommercial capital is to crowd commercial actors into a high-impact opportunity by eliminating real or perceived risk. Volume guarantees are a prime example, and where the Bill & Melinda Gates Foundation intentionally "[takes] on risks where others can’t or won’t.” By guaranteeing demand for drugs and vaccines, they have helped to make a market such that commercial manufacturers can now pursue viable manufacturing strategies that are crucial to enable affordable access to medicine.
Similarly, Big Society Capital has helped de-risk and develop the market for bonds issued by UK charities. Its flexible capital helped issuers and investors overcome initial uncertainty about the feasibility of such investments, which are now an increasingly accepted part of market-rate institutional bond portfolios. In turn, access to commercial capital opens the door for impact at greater scale.
By de-risking nascent markets and first-time fund managers, subcommercial capital steadfastly builds the pipeline of institutional-grade products demanded by more constrained capital. To this point, Vishal Mehta of Lok Capital tells the story of the rise of microfinance. By the time TIAA invested in Lok II in 2009, microfinance was widely viewed as a commercial investment with no return trade-off. But that was not true at the beginning — it was the result of significant grant-funded capacity-building, early bets by international-development finance institutions, and path-breaking policy reforms. As Debra Schwartz of the MacArthur Foundation would say, compelling impact investments are often “made, not found” — and catalytic capital plays a star role.
While some market segments need patient, flexible, and risk-tolerant capital only at the start, others require more permanent flexibility on returns. In these instances, sub-commercial capital is indispensable, whether layered into a blended finance stack — as exemplified by Access — The Foundation for Social Investment — or standing on its own as a more sustainable alternative to a grant.
Taken together, these examples demonstrate that, when coupled with a disciplined investment strategy, subcommercial capital can play a unique role in bridging the wide gap between purely market-rate finance and grants. Indeed, by giving rise to a more mature pipeline and underwriting new sectors, it fuels the growth of the entire impact-investing market.
Work to be done
Despite impact investing’s remarkable growth, there is still more to be done.
By one measure, we still face a multitrillion-dollar finance gap to achieve the Sustainable Development Goals — an urgent imperative for philanthropic leaders to lead.
Foundations and families are poised to bring not only tremendous assets to bear, but also tremendous flexibility. And the need for this type of capital is indeed great — as the supply of commercial capital has vastly outpaced subcommercial. This is not surprising — it simply reflects the fact that many impact investors lack the flexibility to invest across the continuum. As a result, foundations and high-net-worth families are on the front lines of bearing the risks of early-stage innovation and fueling impact in the toughest market segments.
We encourage families and foundations to continue to think creatively about how their unique structures, returns profiles, and appetite for risk can accelerate impact worldwide, both via their investment portfolios and by building the ecosystem that encourages others to follow suit. By understanding the nuances of impact investing, investors can more easily navigate the growing market and move more capital off the sidelines to address the world’s biggest challenges.
Read more at beyondtradeoffs.economist.com.