Impact Investing: the case for a multi-manager approach
Understanding Impact Investing
The umbrella term “environmental, social and governance (ESG) investing” has gained traction in recent years with many investors increasingly seeking ways to align their financial goals with their values. Within finance, ESG is commonly linked to mitigating negative impacts through the implementation of predetermined investment exclusions, such as blacklists. However, the affirmative perspective goes beyond mere avoidance and actively strives to generate measurable positive impacts alongside financial gains.
Various existing legal frameworks pose challenges to clearly defining Impact Investing, especially in the EU where there is still no European-wide definition of Impact Investing (Source: SMSG advice to ESMA on the ESA’s Call for Evidence on Greenwashing, 18 January 2023).
In a nutshell, Impact Investing involves allocating capital to assets that aim to generate positive social and/or environmental changes while achieving financial returns. It is this last point – requiring a financial return on capital – that differentiates Impact Investing from philanthropy, where no financial return is involved.
The Global Impact Investing Network (GIIN), a non-profit organization dedicated to increasing the scale of Impact Investing worldwide, has established four essential characteristics of credible Impact Investing (Source: Core Characteristics of Impact Investing, The Global Impact Investing Network (GIIN), 3 April 2019).
Global initiatives such as the United Nations Sustainable Development Goals (SDGs), which form a set of 17 social, economic and environmental targets to be achieved by 2030, have resulted in an increased prominence of Impact Investing. The SDGs are frequently used as a framework for goal alignment and impact tracking, and a catalyst for Impact Investing. The GIIN estimates the size of the global Impact Investing market to have already topped the USD 1 trillion mark in assets under management (AUM) - a number that shows that Impact Investing has gained momentum and is attracting a variety of investors, from individuals to institutional investors, such as financial institutions, pension funds, family offices, and corporates (Source: Hand, D., Ringel, B., Danel, A. (2022) Sizing the Impact Investing Market: 2022. The Global Impact Investing Network (GIIN), New York).
Figure 1: Impact AUM growth over a five-year period
Source: Global Impact Investing Network (GIIN), 2023 GIINsight: Impact Investor Geographics. The data is based on a sample of 308 impact investors globally who collectively manage USD 371 billion in impact investing assets as of end of 2022.
While Impact Investing is possible across various asset classes,traditionally it has been more focused on private markets. This is due to the direct nature of investments characterized by their long-term horizon and flexibility of owner to drive change. The asset classes typically associated with Impact Investing include private debt, real estate, private equity, venture capital, and infrastructure with investments being made across developed and emerging markets. In addition, these investments are usually diversified across sectors with the strategic goal being to find businesses and projects that create a positive environmental and social impact. The most common industries targeted are healthcare, education, green energy and agriculture.
Figure 2: Capital invested and number of transactions, by asset class
Source: Global Impact Investing Network (GIIN), 2023 GIINsight: Impact Investing Allocations, Activity & Performance. The data is based on a sample of 308 impact investors globally who collectively manage USD 371 billion in Impact Investing assets as of end of 2022. “Other” asset classes include social impact bonds, pay-for-performance instruments and guarantees.
Benefits of a multi-manager approach
While many corporate impact investments originate on the balance sheet, investors are increasingly choosing off-balance sheet structures such as funds and Fund of Funds (FoF) (Source: Stanford Social Innovation Review, Corporate Impact Investing in Innovation, Ryan Macpherson, Claudine Emeott, Ken Gustavsen,Moses Choi, 24 February 2021). What are the benefits of a multi-manager FoF as a vehicle of choice in the context of Impact Investing?
A FoF as a single investment vehicle purchases an array of other funds’ shares/units, with the goal of minimizing risk and maximizing returns, while providing diversification among asset classes, investment managers, locations, strategies, and vintages.
The multi-manager model offers a number of advantages, which complement the execution of an Impact Investing strategy. The first is related to the sheer nature of a multi-manager FoF as a vehicle which pools capital with the ability to invest in multiple impact-focused funds. The scalability achieved through a FoF enables the efficient management and growth of the AUM which in turns provides diversified access to underlying funds with an impact-focused investment strategy.
The selection process of target funds within a multi-manager FoF aims to diversify across geographies and sectors, which avoids domestic bias. The well-diversified portfolio of a FoF creates an impact worldwide, whether targeting climate change, alleviating hunger and poverty, or supporting the development of infrastructure, agriculture or housing, to name just a few possible impact spheres.
Possible impact spheres
There is no doubt that effective Impact Investing is complex and requires specialized expertise, which may not be present in- house for smaller investors or those unfamiliar with the concept. The due diligence in impact fund selection is crucial. A FoF managed by an experienced fund manager employs a a double layer of due diligence through analysis of the target fund and its portfolio manager. The standard due diligence applied by fund managers "investment due diligence (IDD)" and "operational due diligence (ODD)" is expanded in the case that a target fund makes explicit impact claims by performing additional bespoke“impact due diligence” that assesses the projected Impact Investment metrics reported by the fund manager. Both the IDD and ODD include aspects of ESG coverage. The IDD is fund focused and covers ESG integration, screening, ESG risk, and engagement, while the ODD centers around the manager and corporate sustainability, including policies, governance, environmental and social issues and activities.
For some fund managers, the United Nations SDGs serve as a framework for impact measurement. Apart from the SDGs, various other frameworks are frequently used by fund managers to report on the impact of their private assets’ portfolios,including IRIS+, GRI (Global Reporting Initiative) or IMP (Impact Management Project). However, as a significant lack of standardization persists, most fund managers rely on their own criteria when reporting on the impact of their investments.
It is therefore crucial that a FoF fund manager considers the depth of the impact measurement provided by the fund manager (or portfolio manager) in order to understand and assess the following three levels of measurement:
From a FoF manager’s perspective, the main conclusion in relation to due diligence is that any analysis should be on a case-by-case basis (project/investment opportunity-driven and not asset class-based). The due diligence must be selective, specific and tackle the fund managers’ intentions and engagement. There is neither a “one-fits-all” solution, nor is every single fund labelled as “impact” going to deliver the social or environmental goals as declared - the risk of "impact washing" must be avoided.
Another significant benefit of a multi-manager FoF is the network effect. FoF fund managers maintain connections among target fund managers, which may lead to better deal flow and opportunities for investors, such as co-investments. In some cases, it is also a matter of access to specific target impact funds which impose minimum investment thresholds, which are easier to achieve for a pooled vehicle. Additionally, spreading exposure among a set of selected target impact funds minimizes the level of concentration and market risk otherwise associated with a single project investment.
Within the sphere of Impact Investing, the target fund managers need to create effective incentives for both their own investment teams and the management teams of the investees. A common incentive at the level of the target fund managers is implementing carried interest, i.e. sharing of the profits derived from impact investments. At the portfolio company level, management teams are encouraged to strive towards achievement of the impact targets through ratchet clauses in loan agreements linked to impact metrics. Such clauses grant favorable loan terms as long as impact objectives are met or exceeded, fostering a greater collaboration between the fund managers and the investees and boosting overall motivation to meet the impact targets.
A further risk-related benefit of an impact-focused multi- manager approach lies in the continuous monitoring of performance and impact using pre-defined KPIs measured against impact targets such as SDGs. This includes cross- checking the information received from the target fund managers on the investees, consisting of qualitative and quantitative (where possible) data. Key findings from GIIN’s 2023 insights into the impact investing industry confirm that impact investors have become increasingly sophisticated in relation to impact measurement. Most investors (46% of respondents of a 2023 study conducted by GIIN) assess the impact performance at least once a year. The FoF fund managers as allocators can fulfil this investor expectation through reflecting during the monitoring stage. (Source: Hand, D., Sunderji, S., Pardo, N. (2023) GIINsight 2023: Impact Measurement & Management Practice. The Global Impact Investing Network (GIIN), New York).
Addressing potential challenges
One of the obstacles facing Impact Investing through funds lies in the complexity surrounding the myriad of legal frameworks in place, which often lack alignment. In the EU, where impact funds are regarded as the most ESG aligned, it can often be assumed that they automatically fall under the category of Article 9 funds per the Sustainable Finance Disclosure Regulation (SFDR). However, this is not necessarily the case as the criteria laid down in the SFDR are not necessary coherent with the core characteristics of Impact Investing as defined by the GIIN. In the US, the Securities and Exchange Commission (SEC) designed public disclosure rules for ESG funds and came up with their own definition of an impact fund (Source: SEC, Proposed Rule, Enhanced Disclosures by Certain Investment Advisers and Investment Companies About Environmental, Social, and Governance Investment Practices, 25.05.2022), whereby the impact fund must describe the specific impact sought and the progress in its achievement summarized. A FoF manager investing globally needs to keep the disarray among legal frameworks in mind when deploying capital before greater harmonization of the frameworks can be achieved.
Another challenge faced by fund managers concerns the evaluation of the impact of fund investments. The key market insights gathered by the GIIN in 2023 confirm that investors still face obstacles due to inconsistencies in data standards and collection (Source: Hand, D., Sunderji, S., Pardo, N. (2023) GIINsight 2023: Impact Measurement & Management Practice. The Global Impact Investing Network (GIIN), New York). Some areas of impact within the SDG framework, such as those related to climate change and carbon emissions, are easier to measure; others, however, especially those focused on social impact, prove hard to quantify and audit. Additionally, the lack of uniform data methodology among data providers is a point that managers needs to address in the due diligence phase in order to ensure selection of the best-in-class target fund investments.