Impact investing: The secret marriage between philanthropy and finance

In this column, Kipp Baratoff, a Principal at Equilibrium Capital Group, discusses the new trend of investments designed to generate both market rate returns and positive social and environmental impact.

There are certain things we seem to accept as not necessarily pairing very well–cats and dogs, white wine and steak, Frost and Nixon and the Red Sox and the Yankees.  However, there are moments when our time-tested logic fails us and we discover that ostensibly opposing elements not only can co-exist, but also complement each other.  For example, if you re-imagine the Red Sox and Yankees relationship, it is hard to argue that the rivalry does not bring out the best in each team and make for great baseball despite the rabid dislike between each teams’ fan base.  With this in mind, we begin our uncommon and controversial tale of the secret marriage between philanthropy and finance.

In finance, portfolio management is dedicated to creating value and managing risk in the pursuit of generating investment return.  In philanthropy, program management is dedicated to creating value and managing risk in the pursuit of generating social and/or environmental return.  Until recently, these two disciplines have usually been considered separate and distinct.  They are not, and the future balance of your 401k depends on your asset managers understanding why.  Pursuing social and environmental return is increasingly critical to generating superior financial return across a variety of asset classes.  Let me be very clear: this is not about sacrificing return to “do the right thing.”  This is about risk management and value creation in a resource constrained world.  This is impact investing.

History

Impact investing has antecedents in the social unrest of the 1960s, which created significant awareness of the environmental and social consequences of our economic activity.  There are religious antecedents as well.  A number of socially motivated Protestant denominations formed the Interfaith Center on Corporate Responsibility in 1971 to challenge the role of banks and companies in Apartheid South Africa.  However, despite this lengthy history, many of the pioneers of the last 20 years operated on the periphery and were considered activists by mainstream investors. 

This has changed. Today, many institutions around the globe are experimenting with new forms of investment designed to generate both market rate returns and positive social and environmental impact.  The idea of using for-profit investment strategies for this dual purpose has moved from the periphery to the mainstream.  Environmentally and socially intelligent business decisions, which were previously marginalized by unconvincing strategic and financial rationales, now have compelling economic stories.  Institutional investors are no longer asking if; they are asking how to deploy capital.  Some examples:

• U.S. pension assets at the end of 2009 stood at about $13 trillion.  The large institutional pension investors represent some of the most sophisticated and elite global investors like CalSTRS, CalPERS, TIAA-CREF, and the Taft-Hartleys, all of whom have made investments in “green” real estate, an impact-investment opportunity.
• Global financial behemoth Deutsche Bank manages approximately $20 billion in impact oriented investment strategies in renewable energy and positively screened mutual funds. 

These are not activist investors.  These are mainstream, financially savvy institutions.  What was once on the periphery is “crossing the chasm.”

But, What Has Changed?

Investor approaches to market are defined by fundamental beliefs about what generates investment returns.  David Swensen, manager of Yale’s $16 billion endowment, taught us that in his book, "Pioneering Portfolio Management."  Put another way, investor approaches to market are defined by what creates value and what manages risk.  These questions can be deeply personal, pondered over the many moments of a single lifetime.  Put in a financial context, the same two questions are often stripped of their qualitative emotive elements in favor of their equally powerful quantitative and stochastic ones. The latter has begun to shape investor sentiment over the last five years.

For example, let’s examine the public equity asset class and its exposure to water:

It takes approximately 10,000 liters of water to produce one kilogram (2.2 pounds) of cotton.  That equates to about 2,000 liters of water for one cotton t-shirt.  Given the relative scarcity of fresh water on the globe (only 2.5 percent of the world’s water is freshwater and more than 70 percent of that is inaccessible for human use), any piece of a corporate supply chain dependent on water is at risk of raw material price increases cascading through the chain.  This creates a quantitative value at risk that can be measured.  Do your 401k asset managers understand this risk and your public equity portfolio’s exposure to it?