MILLTRUST INTERNATIONAL
 

A primer for evaluating impact investment managers

July 19, 2019

BY Alexander Kalis
MANAGING PARTNER

By Pionline

The growth of impact investing has signaled a staying power that has compelled investment management firms with mainstream investment experience to launch impact funds. Many of these firms have historically stayed away from impact investments or have less impact investing expertise.

New general partner entrants to this style of investing suggests that competition today is stiffer, and mispriced or underdiscovered opportunities are more challenging to identify. The following areas are essential for investors to probe when evaluating an impact investment strategy:

When considering asset managers, one should look for managers with a strong alignment of interests. This is typically exhibited through sensible fund sizes, broad sharing of incentives, appropriate or substantial GP commitments, limited partner-friendly fund terms and tangible track records. In active management, asset owners are betting on a manager’s ability to assemble a team that can execute its strategy, which includes sourcing investment opportunities, determining appropriate pricing, creating value and successfully exiting. However, having a team of accomplished or well-credentialed investment professionals does not always translate into success. Understanding an impact manager’s reasons for entering the space is valuable in learning whether the team can effectively articulate clear motives capable of garnering broad appeal.

Managers seeking impact capital should clearly define their investment parameters and ideally “do no harm” before presenting an impact case. Impact should not be incidental; rather, it should be intentional and tracked, representing a manager’s core investment thesis. For example, an impact fund that makes investments in affordable housing should consider displacement of residents, rising rents and gentrification when determining whether its investment activity provides a net positive impact. This thinking is critical to avoid a host of unintended consequences when making investments believed to have environmental or social benefits.

While the ability of a manager to execute his or her strategy is often driven by experience, so is a clear decision-making methodology that maintains investment discipline. Skilled managers have the temerity to stay the course during stressful periods and use this time to enhance the intrinsic value of their holdings, thereby leaving room to produce compelling returns even without superb timing. The degree to which impact is considered during investment selection highlights whether impact is an afterthought or truly a part of the investment process. The United Nations’ Sustainable Development Goals constitute a universal measurement tool that, while useful, can inadvertently shield managers that loosely assign SDGs to investments where a direct link to impact is arguably weak. It’s critical for limited partners to assess a manager’s processes for managing and measuring impact throughout the investment process. The Investment Integration Project, a nonprofit organization that advocates for the financial ecosystem to embrace tools to effectively operate, highlights a four-step process for analyzing an impact investment: prepare by learning about available options, discover suitability goals, recommend strategies that reflect risk tolerance and financial goals, and manage sustainable investment progress over time through appropriate reporting.

Despite the growing awareness of impact investments, success and failure can be murky. Impact investments cannot solve all problems and are often not the best solution to certain issue areas that could be addressed with different types of intervention where market rate solutions do not exist. The mission-related investment chart below points out the various approaches and the distinctions among impact investments. Mission-related investments are essentially impact investments that target market rate returns. It is broadly understood that impact investments are generally less liquid and create stronger (more measurable) impact than socially responsible investments and environmental, social and governance-focused strategies.

The adage that past performance is not indicative of future results is a reminder that no one has a crystal ball, and the temptation to invest in yesterday’s winners can prove foolish. Evidence of investment excellence or the capability to achieve an acceptable level of social/environmental impact contributes to generating conviction that a manager understands return and impact drivers. Managerial performance generally varies more widely among private assets, which are higher-risk strategies with liquidity constraints. For new firms, there is less meaningful history to assess; however, managers that are beyond their first impact investment strategy should have impact reports that capture the social and environmental impact generated from their past investment strategies.

It’s wise to be skeptical when evaluating investment managers. A private asset investment, for example, can lock up capital for a decade or more. Whether an investment thesis is successful or not, illiquidity limits options for LPs that wish to exit. Operational risks, such as complex GP ownership structures or conflicts of interest, should be well understood and accounted for when assessing events that could disrupt or interfere with a manager’s ability to execute an investment thesis. Investors should also anticipate “impact washing,” portraying an investment strategy as impact-focused when it is not. Three questions that impact managers should be able to answer are: What issues are being addressed? How are profits generated? How are the issues being addressed measured?

Impact investments offer a range of returns, from risk-adjusted, market-rate returns to concessionary returns. Not all investors aim for their impact investments to achieve top or market-rate returns. Similarly, market-rate solutions are not feasible across all impact investment opportunities. Below-market-rate impact investments will be out of contention for some LPs, and suitable for others. Even the best ideas have some percentage of unattractive results across the spectrum of probable outcomes. Further, even the best investors or investment ideas are subject to market vagaries, which can be unforgiving and unpredictable.

Impact investing has been referred to as a houseboat, neither a good house nor a good boat. The retort has been that impact investing is like brunch, better than either breakfast or lunch. Impact investing has moved beyond the fragmented condition in which it formally emerged in 2008 when asset owners struggled to find asset managers and vice versa. Moreover, the ecosystem in which asset owners and asset managers can convene, such as the Five Funds Forum held by Big Path Capital, has widened. However, instead of viewing the amount of capital directed toward impact investments as the proxy for success, the practice of impact investing has a brighter future when social and environmental success is as coveted as strong financial returns.