How innovation in financial security design may boost impact investing in 2015

16 January, 2015 / Articles

Impact Investing is gaining popularity among investors and appears to be immensely attractive amongst the millennials. Estimates of the total size of impact investments vary from US $50 billion (Monitor Institute) to over US $1 trillion ( JP Morgan). Large as these numbers may seem, the size of impact investments pales in comparison to amount of capital available for commercially viable investments. Is this likely to change in 2015? We believe that innovation in the design of financial securities used in impact investing may open a spigot of investment capital not experienced before. This will require a few changes. First, there must be a clear understanding and acceptance of the fact that in equilibrium, just as returns are positively correlated with risks of the investments, the correlation between impact and return is negative. In other words, enthusiasm and euphoria over a shift towards wanting to “do good”must not cloud the reality that this will come at some sacrifice of financial return.

Unfortunately, the hoopla surrounding some impact investments that have also performed well financially, may have had the unintended effect of raising expectations and a distorted belief that one must expect and demand market returns from investments that also produce social good. This is counter-productive. If most impact investments produced market returns and social returns on top of it, no one would need any convincing. All investors would happily invest whether or not they care about social returns; after all financial returns are high enough to compensate for risk taken. Such free-lunch impact investing (FLII) is not what society needs. What society does need is Philanthropic Impact Investors (PII). PIIs are willing to accept a smaller financial return if the investment produces some outcomes that are socially desirable.

Unfortunately, the size of philanthropic investment is limited. This may increase a bit in the coming years but that increase is not likely to be huge. However, innovation in design of financial securities can combine the limited philanthropic capital available with a large amount of commercially available capital. The central idea is to use the limited philanthropic capital to enhance the returns that commercial investors would obtain so as to make financial returns high enough to be competitive and commensurate with the risk borne by commercial investors. In our research on impact investing we show how such securities can be designed. The main result of our research is that commercial investors partially finance the investment in a business that is likely to produce social good by selling securities we call Social Impact Guarantees (SIGs) to Philanthropic Impact Investors (PIIs). If the measured social good produced is smaller, the payout to SIGs is higher and vice versa.

Funds raised from the sale of SIGs enhance the return for commercial investors because when social good is indeed produced (at the expense of financial return), the payout on SIGs is smaller. PIIs understand that if the realized social output is higher, the SIGs they hold will be worth less but if the firm fails to produce the social good, they get compensated by a higher payout on SIGs they hold.

In addition to meeting the benchmarks demanded by commercial and philanthropic investors, such security design also aligns the incentives of the two types of investors. This is key. Not only does this incentive alignment make the pursuit of social objective non-controversial among different types of investors, it also allows corporations to design compensation packages for their managers using standard equity-based compensation contracts and tap and retain managerial talent that is best suited for running the operations and strategy of the firm efficiently.

This obviates reliance on special charter provisions that might otherwise be needed to protect CEOs from pursuing non-commercial objectives.

Securities that achieve this goal require contracts that are based on pre-determined, third-party, observable benchmarks that cannot be manipulated by managers or investors. This may not be easy. But this may not be impossible either. We have seen some progress on this already and will likely see more in the coming years as impact industry continues to mature and become more popular. Innovation in financial security design and creation of credible and observable benchmarks are likely to make a big impact on impact investing in 2015..

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