Additional uses of impact classes
In addition to the role of impact classes in the investment process, there are a number of other prospective uses:
• Research – Impact classes have the potential to be the basis for research on impact risks/returns, as well as a nexus for linking impact and financial risks/returns.
• Communication, education, and marketing – Having a common language and understanding could make it easier to communicate about impact in a variety of settings, including in describing what impact investing is, educating newcomers on the approaches to impact investing, and as part of marketing investment opportunities based on their impact approach.
• Portfolio construction – For some investors, impact classes may provide an additional dimension by which to diversify portfolios.
• Comparison and benchmarking – Defining and agreeing upon high-level categories allows for more ready comparison of impact investment managers on both financial outcomes and impact outcomes. Benchmarks for what level of financial and impact performance can be expected for a given impact class and asset class within a given sector and geography could help set investors’ expectations.
• Standardization – Since impact classes are intended to help better align expectations between investors and investment managers before an investment is made, investment managers may benefit from being able to provide a more standardized set of reporting to investors. Similarly, as a framework for impact classes becomes more widely adopted, practices and principles that help define the boundaries of an impact class will emerge, standardizing categorizations for the field and allowing an investment manager to more easily self-categorize and determine what information to provide for the rest of the market to verify the categorization.
Links to financial risk/return
The field of impact investing longs for more information about the correlations between impact and financial risk and return. Common frameworks that articulate and categorize the impact characteristics of investments could provide a basis for collecting and analyzing data in order to explore these relationships.
Even in traditional markets, categorizations that complement and supplement the core focus on asset classes are critical. Within the realm of alternative investments, for example, hedge funds and private equity both invest primarily through “equity” as an asset class, but they generate their returns in different ways depending on strategy: For hedge funds, this could be long/short equity, market neutral, event-driven, or global macro (among others); and for private equity may include venture, growth, buyout, or special situations.
These kinds of categories help bucket investment managers looking for similar types of investments with similar approaches to deriving value and comparable risk profiles. The bucketing facilitates benchmarking, which is essential for investors in determining the appropriate financial returns relative to risks.
In impact investing, the same type of clustering on the basis of impact characteristics and practices can provide similar benefits for comparing investments. For example, clustering could help distinguish managers supporting untested business models in new markets from those working with large, established companies. In addition, some managers put significant resources into measuring and managing for impact, others have chosen not to, do not need to, or cannot. Impact classes could add a layer of information that helps more clearly distinguish the different buckets within which like investments can be compared.
The exploration of these elements of impact practice alone is important for some impact investors in their investment decisions. Many investors, though, will also want to know the correlation between an investee’s impact goals and their financial goals: a concept Bridges Ventures refers to as “alignment.”
Like the hedge fund and private equity strategies above, impact classes would not, a priori, be assumed to have a specific financial risk/return profile, but rather these correlations would emerge over time and likely surface different conclusions in different impact sectors and geographies.
For example, a microfinance institution that shifts resources to emphasize impact measurement relatively more than its peers may underperform those peers in a given year. Over time, though, the organization may prove better at creating long-term value and demonstrate better financial performance and/or less risk, given the potential benefits of having invested in its measurement practices (again, only time and data would tell).
In other geographies, sectors, or stages of market or company development, over-investment in impact practices may create a drag on financial returns. Whether this drag is an acceptable “tradeoff” for the level of impact return and/or level of evidence of impact is a choice each investor will need to make, but currently has difficulty making, arguably because the impact element of the impact/financial correlation equation remains vague and poorly defined.
Ultimately, impact classes may only have a loose connection to financial returns, especially if they span asset classes, geographies, and sectors. It may be possible to surmise that certain investments with particular impact goals and standards for impact evidence are likely to have a wider range of potential deviations from “market-rate” returns. However, a better categorization of investee and investment manager impact practices is needed to lay a clearer path for this exploration of the relationship between financial return and impact.