THE BLOG
05/07/2012 12:58 pm ET | Updated Jul 07, 2012

The Really Truly Transformative Potential of Impact Investing

Money managers pay attention: Impact investing -- investment for financial return in addition to measurable social or environmental benefit -- will change the way you do business. Really. Truly.

For the first time, in a systematic way, impact investing provides an alternative to the axiomatic idea that the value of capital ought to be measured solely by the risk-adjusted financial return that it can generate, regardless of costly externalities and/or non-financial benefits that are unaccounted for.

The idea of a return on capital that includes financial and non-financial components is central to impact investing because, in part, it is hard (but not impossible) for impact investing to compete on a conventional basis. When JP Morgan recently asked investors what financial returns they expect from their impact investments as compared to traditional investments, the response was 19 percent in developed market private equity funds, below the benchmark return of 29 percent, and 4 percent in developed market corporate debt, below the benchmark return of 11 percent.

As a result impact investors often need what the field refers to as "subsidy" in order to make viable the higher risks and transaction costs of working with dual purpose businesses, affordable housing projects, and new clean technologies. That subsidy typically comes in the form of capital with concessionary financial return expectations, including from governments (think the SBA's Impact Investment Initiative), private and charitable foundations, and individuals with the flexibility to invest how they wish.

In fact explicit subsidy is precisely what distinguishes impact investing, in two ways. First, impact investing requires that social or environmental outcomes are rigorously quantified or otherwise evaluated. This allows investors (whether public or private) to understand what their subsidies are paying for. Second, the importance of weighing the best use of limited subsidies necessitates a significant role for government. The winners of this year's Impact Investing Challenge, a pitch competition "focused on designing investment vehicles that create sustainable impact," were not from a B-school, but rather the School of International Policy Studies at Stanford University.

Moreover, the need for subsidy is the X-factor that will ultimately lead impact investing to transform all investing, although by then we will have retired the term "subsidy" and replaced it with "impact premium" or some other descriptor.

Why? Because as the growth of impact investing makes it possible to track the social and environmental outcomes generated by our investments (i.e., through jobs created in low-income communities, schools built, crime reduced, lives saved, or greenhouse gases offset) more of us will be willing to pay for those outcomes with some discount -- "impact premium" -- in the financial returns we might have otherwise earned. In effect, investors will consider "total return," rather than just "financial return."

Put another way, the process of allocating subsidies individually and collectively -- an inherently fluid but purposeful, values-driven exercise that is akin to Time's "responsibility revolution" and distinct from the hard-headedness of financial analysis -- is itself the reason there is growing interest in impact investing.

Multiply individual predilections by the thousands or millions and you get a feel for institutional change. For example, it may be a better strategy in the long run, and in the best interest of all beneficiaries, for a public pension fund to create quality local jobs through a "targeted" impact investment in its home city or state seeking financial return in addition to economic development, even if the cost of doing so is a lower financial return than from comparable investments that are not targeted.

For now, without the more robust networks, intermediaries, and best practices in impact investing that characterize traditional investment markets, the example above hints at cronyism and is plainly anathema. Institutional investors are rightly focused instead on the impact investing sub-sectors that have the potential to deliver financial and social returns concurrently (with or without subsidy from others), for example in renewable energy, emerging domestic markets, sustainable urban development, and infrastructure.

The example will become less provocative in years to come, however, and speaks to the wholesale shift in investment practice that impact investing is making possible.

I am excited to support the Huffington Post in providing additional commentary on impact investing and look forward to your contributions to that dialogue as readers and writers. Keep your eye out for more on the role of government in impact investing, the development of systems and processes for evaluating social and environmental performance, key learnings from impact investors with a track record of success, innovative financial strategies layering subsidized and market-rate capital, and the special needs and strategies of institutional investors.